Rio Tinto’s Iron Ore Benefit Hits A Peak

Rio Tinto has spread the benefit of surging iron ore prices in the first half but most brokers believe sustaining such a high rate of earnings will be difficult heading into 2020.

-Record interim cash return of US$3.5bn
-Operating difficulties prevail at the Brockman hub
-A drop in iron ore prices could be a catalyst for pressure on the shares

By Eva Brocklehurst

Iron ore was the dominant feature of the first half results for diversified miner Rio Tinto ((RIO)), as the price skyrocketed in the period. Still, expectations were high and the results missed some broker forecasts. A higher iron ore price provided a US$2.7bn benefit for operating earnings (EBITDA), delivering a 65% return on capital employed for the segment. Yet lower volumes induced a 9% increase in unit costs.

The strength in the iron ore price more than offset a -8% decline in Pilbara iron ore shipments in the half-year, which was caused by bad weather, a fire at Cape Lambert and operating issues in the Greater Brockman hub.

A US$3.5bn cash return was a record for the company at an interim result. Morgans expects Rio Tinto has considerable potential to continue paying significant returns, even in the event the iron ore price eases. The company delivered a first half dividend of US$1.51 along with a special dividend of US$0.61. UBS believes this should be viewed favourably, as total dividends reflected 90% of free cash flow generated over the half.

First half underlying earnings were slightly below the broker's expectations because of higher costs in iron ore and provisions for onerous contracts. Dividends were weaker than Macquarie expected, in line with the miss to overall earnings versus the broker's forecasts.

Shaw and Partners, not one of the seven stockbrokers monitored daily on the FNArena database, believes the mid year special dividend represents a subtle shift in capital allocation policy, as specials were previously meted out at the full year results. The broker has a Buy rating and $110 target.

Ord Minnett agrees that the pay-out was just a pulling forward of returns that were expected at the 2019 results. The broker observes the share price has weakened following a change in market sentiment, stemming from re-start of Vale's iron ore production as well as modestly higher iron ore and steel inventory in China.

Nevertheless, the iron ore price appears resilient at just below US$120/t and the broker suggests this is likely to continue in the near term. Should the share price continue to soften, Ord Minnett would look to review its recommendation.

Iron Ore Concerns

Higher costs, particularly in iron ore, mean UBS marks down 2019 estimates for iron ore earnings, to US$12bn. Rio Tinto has acknowledged operating challenges in the first half of 2019 and has taken actions to optimise its performance across the iron ore system.

Operating difficulties have affected mine sequencing at the Greater Brockman hub which will mean increased waste movement over 2019/20. Rio Tinto had to cut volumes to preserve the specifications of its flagship Pilbara Blend.

Production guidance has been maintained for 2019, although Macquarie notes guidance was reduced twice in the first half and could be under further pressure given major rail maintenance scheduled for October.

Credit Suisse agrees there is work to be done to get on top of the uncertainties in the Pilbara.The broker expects 300mt in 2019 but, taking into account the Brockman issues and elevated rail maintenance, risks appear to the downside. The broker downgraded the stock to Underperform in July, believing iron ore prices would peak in the current quarter.

Supply from both Brazil and Australia is increasing and, while there is a risk the call has been made too early, Credit Suisse assesses there is more downside than upside as 2020 approaches. The broker fails to envisage how, on a 12-month view, even a high-quality miner like Rio Tinto can offset declining prices for its major product.

UBS believes the current iron ore price is likely to drive higher earnings in the second half but agrees this is unsustainable, as supply is lifting and demand in China is expected to be softer. The rate of draw on Chinese port inventory has slowed and Credit Suisse assesses, once inventory is move up again, the resultant fall in iron ore prices will be a catalyst for pressure on Rio Tinto.

Citi now assumes Pilbara shipments of 340mt in 2020 and its 325mt assumption for 2019 is unchanged, although acknowledges Rio Tinto needs to operate at 340mtpa in the second half.

Besides Iron Ore

Slower restructuring in China and the resumption of shipments from Rusal meant the aluminium earnings fell short of expectations. Morgans notes, adding to the soft performance, Rio Tinto's aluminium business was loss-making, amid sustained cost pressures driven by high energy costs in Australia. Rio Tinto expects demand to recover in the automotive sector in China, which will lift requirements for aluminium.

Copper sustained a -11% decline in price in the first half. Production at Kennecott was constrained and there was natural grade decline at Escondida. Global mine supply is expected to fall by -1% in 2019 and Rio Tinto envisages a balanced market in copper over the next five years.

Copper projects that are in the wings include Winu in Western Australia and Resolution in Arizona. Impairment charges were largely associated with the Oyu Tolgoi underground project, where Rio Tinto has flagged to 16-30-months delay to first production. Credit Suisse does not expect any new update from Oyu Tolgoi until 2020.

The company has approved construction of the Zulti South mineral sands project in South Africa and first production is scheduled for late 2021. Rio Tinto has also entered into an agreement with China National Uranium Corp for the sale of its 68.6% interest in the Rossing uranium mine in Namibia.

FNArena's database has two Buy ratings, four Hold and one Sell (Credit Suisse). The consensus target is $101.75, suggesting 8.8% upside to the last share price. Targets range from $91.52 (Morgans) to $114 (Macquarie). The dividend yield on 2019 and 2020 forecasts is 7.3% and 6.2% respectively.

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